Certain transactions affect the revenue or expenses of two or more accounting periods. The purpose of adjusting entries is to assign to each accounting period appropriate amounts of revenue and expense.

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ACCRUALS & DEFERRALS

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ADJUSTING ENTRIES
 Certain transactions affect the revenue
or expenses of two or more accounting
periods.
 The purpose of adjusting entries is to
assign to each accounting period
appropriate amounts of revenue and
expense.

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The Need for Adjusting
Entries
 Examples of revenue and expenses that
affect multiple accounting periods: Insurance
policies, magazine subscriptions.
 Adjusting entries are needed at the end of
each accounting period to make certain that
appropriate amounts of revenue and
expenses are reported in the company’s
income statement.

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Types of Adjusting Entries
 Most adjusting entries fall into one of
four general categories:
1. Converting assets to expenses.
2. Converting liabilities to revenue.
3. Accruing unpaid expenses.
4. Accruing uncollected revenue.

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1. Converting Assets to
Expenses
 When a business makes an expenditure that
will benefit more than one accounting period
the amount usually is debited to an asset
account.
 At the end of each period benefiting from this
expenditure an adjusting entry is made to
transfer an appropriate portion of the cost
from the asset account to an expense
account.

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Converting Assets to
Expenses
 An adjusting entry to convert an asset to
an expense consists of a debit to an
expense account and a credit to an
asset account.
 Prepaid expenses are assets; they
become expenses only as the goods or
services are used up.

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Converting Assets to
Expenses – Shop Supplies
 Lets suppose a company purchases the
shop supplies for 3 months – reason
economy of bulk purchase. Journal
entry for this purchase will be
Shop Supplies……………… Debit
Cash …………………. Credit

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Converting Assets to
Expenses – Shop Supplies
 It is not practical to make journal entries every
few minutes as supplies are used. Instead, an
estimate is made of the supplies remaining
on hand at the end of each month; the
supplies that are ‘missing’ are assumed to
have been used.
 Adjusting Entry: At the end of the month:
Supplies Expense…………….. Debit
Shop Supplies ……………… Credit

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Converting Assets to Expenses –
Insurance Policies
 Journal Entry for purchase of Insurance
Policy for 1 year:
Unexpired Insurance ……….. Debit
Cash ……………………………….. Credit
 Adjusting Entry at the end of each
month:
Insurance Expense ………….. Debit
Unexpired Insurance ……………. Credit

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An Expired Asset Becomes an
Expense
BALANCE SHEET
Assets
Shop Supplies
Unexpired Insurance
INCOME STATEMENT
Revenues
Expenses
Supplies Expense
Insurance Expense
Cost of supplies
and insurance
policies that will
benefit future
periods
As supplies
and insurance
policies are
used or expire

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The Concept of Depreciation
 Depreciable assets are physical
objects that retain their size and shape
but that eventually wear out or become
obsolete.
 Examples of depreciable assets:
Buildings, all types of equipment,
fixtures.

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 Each period, a portion of a depreciable
asset’s usefulness expires.
 Therefore, a corresponding portion of its
cost is recognized as depreciation
expense.
The Concept of Depreciation

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 What is Depreciation? In accounting, the
term depreciation means the systematic
allocation of the cost of a depreciable asset to
expense over the asset’s useful life.
 The rationale for depreciation lies in the
matching principle – offset a reasonable
portion of the asset’s cost against revenue in
each period of the asset’s useful life
The Concept of Depreciation

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 Depreciation is only an estimate.
 Straight-Line Method of Depreciation:
Depreciation Expense (per period) =
Cost of the asset / Estimated useful life
How to determine useful life of an asset? It’s
just an estimate.
The Concept of Depreciation

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 The adjusting entry for monthly depreciation
of building: Purchase Value = Rs. 500,000.
Useful Life = 10 years = 120 months. Monthly
depreciation expense = Rs. 4,167
Depreciation Expense : Building …… 4,167
Accumulated Depreciation : Building ….. 4,167
 How accumulated depreciation appears in the
balance sheet:
Building…………………………………………… 500,000
Less: Accumulated Depreciation : Building ….. (4,167)
495,833
The Concept of Depreciation

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2. Converting Liabilities to
Revenue
 In some businesses, customers may pay in
advance for services rendered in later
accounting periods. Examples, yearly
subscriptions for magazines, quarterly
membership fee for health club, airline ticket
purchased 2 months in advance of scheduled
flight.
 For accounting purposes, amounts collected
in advance do not represent revenue,
because these amounts have not yet been
earned.

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 Journal Entry for Unearned (Deferred)
Revenue:
Cash ………………………….. Debit
Unearned Revenue Account … Credit
 When a company collects money in advance
from its customers, it has an obligation to
render services in the future. Therefore,
balance of an unearned revenue account is
considered to be a liability, it appears in the
liability section of the balance sheet.
2. Converting Liabilities to
Revenue

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 When a company renders the services for
which customers have paid in advance it is
working off its liability to those customer and
is earning the revenue.
 Adjusting entry to transfer an appropriate
amount form the unearned revenue account
to a revenue account:
Unearned Revenue Account ……. Debit
Revenue Account ……………… Credit
2. Converting Liabilities to
Revenue

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 Journal Entry for receiving Rs. 36,000
as yearly rent of the building on Jan. 01:
Cash……………………………. 36,000
Unearned Rent Revenue ……… 36,000
 Adjusting Entry for the rent at the end of
Jan. 2006:
Unearned Rent Revenue ……... 3,000
Rent Revenue Earned …………. 3,000
2. Converting Liabilities to
Revenue

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2. Converting Liabilities to
Revenue
BALANCE SHEET
Liabilities
Unearned Revenue
INCOME STATEMENT
Revenue
Revenue Earned
Value of goods
or services to
be provided in
future periods
As the goods
or services
are provided

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3. Accruing Unpaid Expenses
 This type of adjusting entry recognizes
expenses that will be paid in future e.g.,
salaries of employees, interest on
borrowed money.
 Since these expense will be paid at a
future date the adjusting entry consists
of a debit to an expense account and a
credit to a liability account.

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 Accrual of wages (or salaries) expense: Most
of the companies pay monthly salaries in the
1st week of the month. An adjusting entry at
the end of month is needed to show these
unpaid salaries.
Wages Expense ………………. Debit
Wages Payable ……………….. Credit
 When the wages are paid the following entry
will be made:
Wages Payable ………………… Debit
Cash …………………………… Credit
3. Accruing Unpaid Expenses

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4. Accruing Uncollected Revenue
 A business may earn revenue during the
current accounting period but not bill the
customer until a future accounting period.
 Any revenue hat has been earned but not
recorded during the current accounting period
should be recorded at the end of the period
by means of an adjusting entry.

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 The term accrued revenue often is
used to describe revenue that has been
earned during the period but that has
not been recorded prior to the closing
date.
4. Accruing Uncollected Revenue

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4. Accruing Uncollected Revenue
Examples Include:
• Interest Earned
• Work Completed But Not Yet Billed to
Customer

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 Example: QuickFix Car Co. provided car
maintenance service to ABC Co. for Rs.
1,500 and send the bill. As no amount is yet
collected the following entry will be made:
 Journal Entry:
Accounts Receivable 1,500 (DEBIT)
Car Maintenance Revenue 1,500 (CREDIT)
4. Accruing Uncollected Revenue

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 When QuickFix Co. will receive the
amount of bill from ABC Co. it will make
the following entry:
 Journal Entry
Cash 1,500 (Debit)
Accounts Receivable (Credit)
4. Accruing Uncollected Revenue

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Costs are matched with revenue
in two ways:
 Direct association of costs
with specific revenue
transactions.
 Systematic allocation of costs
over the “useful life” of the
expenditure.
Adjusting Entries and Accounting
Principles

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An item is “material” if knowledge of the
item might reasonably influence the
decisions of users of financial
statements.
Supplies
Light bulbs
Many companies
immediately charge
the cost of
immaterial items to
expense.
The Concept of Materiality

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End of Chapter 4